This article has been written by Rachit Singh, pursuing the Diploma Programme in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho.

Introduction

According to recent survey results conducted by Mercer, around 43 percent of the mergers and acquisitions transactions are called-off, renegotiated regarding finches, or suffer delay while being undertaken by the concerned parties. Both opportunity cost and monetary funds are wasted due to the fact that the management of two or more different entities involved in an M&A transaction failed to address the issues pertaining to culture. To avoid such scenarios while executing an M&A deal, the management should conduct a thorough cultural due diligence in order to mitigate the risks revolving around the deal. This article aims to discuss the significance of cultural due diligence, the procedure of conducting the process, and its impact upon an M&A transaction.

Cultural due diligence

The professionals involved in M&A transactions tend to move at a rapid pace in order to get the transaction done quickly but this rapidness could lead them into being reckless. Culture is one such aspect of an M&A transaction that is overlooked by the management as they are often occupied with the strategic, financial, and legal due diligence process. Lack of cultural due diligence causes issues in the deal and eventually blocks the transaction. 

Cultural due diligence is not mandatory by any statute unlike legal and financial due diligence, it is a process of defining, investigating, and assessing the cultural backgrounds of two or more distinct business entities, this process also facilitates an enterprise in recognizing and assessing the area of similarity and differences among the parties involved in the transactions that will impact the efforts of integration and achievements regarding strategic objectives. Cultural due diligence is a process where the values, visions, missions, and beliefs of the target entity and their compatibility with those of the organization acquiring it are assessed. The areas around which this type of due diligence process is conducted are –

1. Visions;
2. Mission;
3. Value;
4. Belief;
5. Leadership styles;
6. Perceptions about the organization, its management and personnel, and their approach towards the business.

The process of cultural due diligence facilitates an enterprise entering into an M&A deal in various ways, such as –  

1. In identifying the culture of the target entity and its orientation regarding the business.
2. In understanding the concerns and problems regarding their culture in the company.
3. In avoiding potential red flags.
4. In preparing the company management for recognizing and acting upon any future cultural disputes post-merger or acquisition.    

Difference between cultural and HR due diligence

Often people confuse cultural due diligence with HR but they are quite different in nature as HR due diligence focuses primarily on the past and potential headcounts of the target entity, patterns of turnover by the company personnel, profile of senior leaders and managers as well as their compensation structure to resolve the inequities occurring in the compensation plans between the concerned entities and other similar issues. 

HR due diligence facilitates the entity in identifying the differences in the decision making and it also uncovers red flags causing hindrance in the deal, and such process also reduces the risk of losing out on the talented and hardworking employees of the target entity. HR due diligence investigates certain operational risks which critical for a smooth undertaking, such risks include –

1. Workplace relations such as employee turnover, disputes among employees, performance, etc.  
2. Remuneration and benefits such as policies of the target company regarding employee leave/vacation, bonus criterion, compensation, etc.
3. Organizational culture such as values, leadership, cooperation, etc.
4. Agreements regarding employment of the people working for the target entity.
5. Target entity’s HR policies and their procedure.

Such due diligence aims to avoid the following red flags, such as – 

1. Risk of losing talent during the M&A transaction.
2. Productivity decreases.
3. Mismatch of culture, procedure, and communication.
4. Internal disputes are caused due to differences of opinions and approaches.

Thus, certain aspects of cultural due diligence are included in the process of HR due diligence but the process of cultural due diligence is quite vast as it not only covers the personnel of the target company but their approach, visions, and mindset. Hence it is critical for an enterprise to dedicate a group or team responsible for caring cultural due diligence as it facilitates the company in recognizing the potential barriers pertaining to the deal.  

Culture as a criterion for identifying a target organization 

By having considered culture as a criterion for identifying a target, an acquirer can identify the compatibility and fitness regarding the work, business, and leadership culture of the target firm. This will ensure the smooth working of the potential merger or acquisition. By setting up “culture” as a criterion for identifying a target, the acquiring organization can weed out the organization (s) if it seems culturally different from the list of entities to be potentially targeted for a possible merger or acquisition, it assures the acquirer in recognizing the most suitable target for the purpose of merging or acquisition. 

For example, if Versace desires to merge with a business in order to expand its presence in the Asian market then first, it must set out a list of potential targets in the Asian fashion market then identify the most suitable ones by assessing and matching their work culture with its own organization. The target of Versace must share their visions, mission, values, and orientation regarding the fashion business, if all these criteria are deemed fit by the management of the acquirer then Versace can go ahead with the merger and expand their horizon. Such practice ensures the acquirer or the merging business that both potential parties are compatible with each other and share a similar vision for their respective business future.

Significance of cultural due diligence

The process of cultural due diligence essentially facilitates a business in the following ways;

1. It helps in meeting costs and generating higher revenue synergy if an enterprise manages to integrate culture during an M&A transaction.
2. It helps in prioritizing the elements which the entity wants to protect and nurture in order to achieve its objective. If the entities involved in an M&A deal are revenue-oriented then they must focus upon culture pertaining to operational discipline rather than maintaining a customer base or capturing cost synergies.
3. Companies that acquire targets based upon the talent or capabilities of their employees then conducting cultural due diligence becomes a necessity as the work culture of the target entity is the primary reason as to why the acquirer intends to acquire that particular entity.
4. Cultural due diligence also helps in highlighting the true rationale behind a potential business transaction because sometimes an entity intends to merge with another business by just looking at their books of accounting i.e. their profit margins, such a deal might eventually turn into a failure if the parties involved in the transaction fail to address the culture of their target entity and in future, their visions and ideas do not match hence causing the venture to be a failure.        

Framework for conducting a cultural due diligence process

The cultural due diligence process includes the following steps – 

1. A company must figure out the cultural elements which are most important to achieve the objective of the deal. For instance, if the parties involved in an M&A transaction are primarily focused upon cost efficiencies/synergies then they should assess the culture of each other regarding their financial management, leadership, and operational discipline.  
2. The cultural due diligence team should be formed by the entity entering into an M&A transaction. The members of this team must be equipped with adequate experience and skills pertaining to relationship building and networking. The primary focus of this team is to check whether the entities involved in the M&A transactions share a similar set of goals and objectives, and to what extent they are compatible with each other.
3. Cultural assessment should be conducted by setting out a list of cultural indicators and complying with the same while comparing the cultures of the entities involved in the transaction. 
4. A company must conduct a “dipstick” diligence which involves a broad understanding of the culture of the other entity. This practice is primarily focused upon the gathering of information about the target company through public sources/databases, informal sources, and other casual observations regarding their culture by various sources such as chat with their employee, a quick visit to the target entity, etc. 
5. The information gathered from various formal and informal sources must be compiled with, analyzed, and validated by the management of the concerned entity.

Worth of ‘culture’ in the corporate world

GE capital considers culture and people issues while undertaking an acquisition process. It considers compatibility with respect to the employees and cultural issues as a non-negotiable phenomenon and core to their M&A procedure.  The same approach towards culture is adopted by one of India’s largest conglomerates, TATA. The Tatas’ do not go into an acquisition or merger process with an organization that does not share their goals, objectives, and values. The Tata group neither compromises nor negotiates upon its five core business values namely integrity, understanding, excellence, unity, and responsibility. Such a statement clearly communicates the importance Tata Group shows towards cultural orientation, they believe that complying with the aforementioned value facilitates them in identifying the most suitable organization for a merger or an acquisition.  The Tata Steels’ acquisition of NatSteel Asia is a prime example of a culture-driven acquisition process. The management team of Tata while negotiating the terms of the acquisition deal realized that NatSteel Asia also shares their work philosophy, style of working, culture, and ethos. Thus these alignments facilitated Tata Steels in going ahead with the decision of acquiring NatSteel Asia.   

Conclusion

Cultural due diligence is an essential part of the M&A transaction as it facilitates an entity in acquiring knowledge about the work culture and discipline of the target firm. The difference between a successful merger or acquisition transaction and a troubled one is that the latter transaction failed to recognize and assess the culture during the due diligence process while a successful one is executed with a holistic and exhaustive approach towards culture at an early stage and a strong focus is laid down upon the issues pertaining to the employee. Hence cultural due diligence does matter in an M&A transaction.   

References

1. https://www.willistowerswatson.com/en-US/Insights/2019/10/successful-ma-requires-cultural-due-diligence.
2. https://journals.sagepub.com/doi/pdf/10.1177/0256090920130201.
3. https://www.dailypioneer.com/2018/columnists/avoid-culture-clash-during-merger.html#:~:text=Another%20example%20of%20merger%20gone,disastrous%20marketing%20campaign%20for%20Snapple.
4. https://www.mckinsey.com/business-functions/m-and-a/our-insights/in-conversation-culture-in-m-and-a#.
5. https://www.controlrisks.com/our-thinking/insights/setting-up-a-deal-to-succeed.
6. https://www.ansarada.com/due-diligence/hr.

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